Measuring Business Profitability
There are three ways to measure profitability: for the principals, for the investors and for the business as a whole. Consider they hypothetical case of an entrepreneur who leaves a $50,000 salaried job to start a business. In the first year the business clears $125,000, which becomes the entrepreneur’s salary. The business as a whole shows no profit, as that salary is another business expense, but the entrepreneur she has profited well from the startup.
Likewise, payments to investors can be structured so they’re earning interest even when the business is officially breaking even or losing money.
Time Frame to Profitability
Bleeding away the company’s revenues for your own income isn’t usually a good business strategy. A rule of thumb for an entrepreneur says that in the first year of running your own business successfully you’ll take less than your prior salary, and re-invest most of your net revenue in the business. In the second year, if all goes well, you can draw your former salary. In the third and subsequent years, you can draw a larger salary – plus any proceeds from his ownership of the company if he sells shares or outright ownership.
The actual time frame to company profitability is entirely dependent upon how much start-up capital is needed to create the products and services, and how much money is drawn from the company for compensation and investor servicing.
Identifying Corporate Profits
Corporate profitability is whatever monies remain after all expenses are accounted for, including salaries of the principals and staff and payments to investors. If these profits are reinvested in marketing or additional product development, they are removed from the profit sheet – which means a highly successful but swiftly growing company can show no profits on paper, or even a loss if investment capital is still flowing. Amazon famously operated that way for much of its history, and with great success. When corporate profits are invested as cash or liquid assets for future corporate use, the company can begin to show a profit.
How Much Profit?
Beginning entrepreneurs should distinguish between what is called “ramen profitability” and actual corporate profitability. Ramen profitability is enough cash flow that the founders of a company can sustain a minimal lifestyle as quickly as possible without the need to resort to outside jobs or income. “Shoestring” start-ups that need very little capital to launch can reach ramen profitability in a very short time, but it may take far longer for the founders to draw a decent salary and also leave enough cash on hand for the business to show a profit.
Further Considerations for Profitability
Consider your goals when designing your ledger sheets. Your business only needs to show a formal profit if there is a genuine business interest in doing so: Investors may be easier to find if the business is profitable on paper, which in turn implies good reason to draw the smallest possible salary.
However, if your goal is to live well off the proceeds of your business while enjoying the ancillary benefits of being your own boss, it may never be necessary for your business to show a profit. It can also be advantageous from a taxation perspective, minimizing the taxes your company pays over the long term.